This article was posted on Sunday, Sep 01, 2013


If the purchase was made for the right reasons, there are few truly compelling reasons to sell. You’re moving toMissouri? Can’t you hire a Certified Property Manager to handle your local properties? Disagreeable tenants? If you sell, the current tenant problem will be baked into the purchase offer. Red tagged building? The prospective buyer will notice and will surely adjust his offer accordingly. Shoe sale at Nordstrom’s? Ok, let’s talk about that: the options are to either sell or refinance. The choice made can have a meaningful impact on future wealth.

Presume a 12 unit building in a good area with a Net Operating Income of $175,000, mortgage payments are $72,000 annually, and your cash flow is $103,000 ($175,000 NOI minus $72,000 debt service). The property has as current fair market value of $2,500,000 (NOI divided by estimated 7% cap rate). Costs of sale will probably be about 5% brokerage fee and 2% third party fees (seller’s portion of the escrow costs, etc). Sometimes the total sales fees are a little under this estimate and occasionally a touch over, but 7% is a probably a good working estimate. Take 7% from $2,500,000 and we’re down to $2,325,000.

Subtract the present loan of $1,250,000 and the before tax cash to seller is $1,075,000. Subtract taxes due at sale (LTCG @ 20% plus the new 3.8% ObamaCare surcharge on capital gains) and the net to seller is $820,000. Just for a moment, reflect on the result of selling: You turned your $1,250,000 equity ($2,500,000 minus existing loan of $1,250,000) into $820,000 cash, a 34% haircut. Since it would probably take at least 30% down to buy your own property back what happened was that the sale kind of moved you sideways: after paying the broker, the tax men, and the old mortgage you managed to turn $1,250,000 gross equity into $820,000 net cash. If my husband did that he’d be washing dishes for a month.

Alternatively, you could have refinanced. Given the same data as above, if you had elected to refinance you probably could have achieved a 75% LTV loan of $1,875,000. You won’t be paying a sales commission. There will, however be fees and charges to get your new loan. The amount varies with the lender.

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There’s no immediate tax when refinancing, so you don’t pay capital gains and you don’t pay the ObamaCare surcharge. Subtract the present loan balance of $1,250,000 ($1,875,000 minus $1,250,000) and you can expect a check from escrow for about $625,000 less fees and charges –  and you still get to keep your property. You’ll be pulling money out on the refi, so the payments will be higher, as you would expect. Figure a cash flow of about $55,000 right after the refinance.

A refinance happens a lot quicker than a sale. With a sale you first have to find a buyer before the clock starts on processing the buyer’s loan request.

Option One                                               Option Two

$820,000 cash                                            $625,000 cash

Lengthy wait                                             Much quicker

Loses property / loses rental income      Owner keeps property & income          

In this example, a sale will provide an extra $195,000 cash when the sale closes. But you would no longer have the net rental income.

A refinance would generate $625,000 cash plus the revised net rental income of $55,000 a year. At $55,000 a year, it would take about 3.5 years for the new net rental income to offset the larger cash out from the sale.

The choice of selling (pulling out the equity minus fees, costs, and taxes but losing a proven stream of income) or refinancing (pulling out most of the equity, significantly fewer costs, no immediate taxes and retaining a proven stream of income) can have a meaningful impact on future wealth.

After Selling              

But, still, there are sometimes good reasons to sell. Your kids may be out of state and you want to move your investments to where the kids are because the apartments will eventually be theirs. Perhaps you have just had it up to here with ever-diminishing property rights in California. You may simply have lost interest in rentals, have no kids, and be retiring from the business. More likely, the reason to sell is your new husband, Raul, the hunky former pool boy, who wants to act rich.

Moving your investments is feasible. As noted earlier, if the loan on your property is about half of the gross sales price, the net money you receive will marginally buy the same property back. But we’re selling property in a high priced area, and apartments inTexas(for example) are a lot cheaper. You know those 12 units you just sold and netted $820,000 cash? Right now there are 32 units inDallasoffered at a $1,750,000 (7% cap). You could put 40% down and have a generous cash flow.

Unless you’re moving your investments, a sale doesn’t require buying a replacement building. That gives both the buyer and the seller more options. For instance, if the building is (or is nearly) mortgage free you could carry back the financing on the sale. It would have to be a first mortgage because second mortgages are generally forbidden on properties like this.

There are various reasons you may be asked to carry back the financing on the building you sell, but the most common is that the borrower wouldn’t qualify for a bank loan.

An institutional lender requires the borrower to prove a history of good character, to have sufficient collateral for the loan, and demonstrate the capacity to repay.

Character:  “Character” is having a sufficient history, from a third party lender, of making debt payments on time and in full. A note from Aunt Amanda that, yes, Lucy’s a good girl and, yes, she finally paid back the $100 she was lent years ago is usually not actionable. A long history is better than a short history. Widely diverse lines of credit (home, car, credit cards, furniture, etc.) are thought better than a single credit card with a $250 limit that’s been maxed out for years. Having the latent capacity to borrow, on an unsecured basis, significantly more than is owed (having a “credit reserve”) is important because it is considered to show self-control. Multiple credit cards with, for example, a combined limit of $100,000 against which only $12,000 is owed is generally considered a good thing.

Collateral:  The collateral is the property used as security for the mortgage. Notice that the collateral is the entire property while the mortgage is only 70 – 75% of its appraised value. This difference (in a purchase, the down payment) is a cushion that protects the lender from taking the first loss in a foreclosure. A significant down payment does not guarantee against having to take a property back, but it does reduce the risk of loss to the lender when it happens. The relationship of the Loan to the building’s Value is the LTV ratio (loan amount divided by value). Clearly, the amount of the loan is affected by the required LTV ratio. A high LTV ratio means a bigger loan; a low LTV means a smaller loan.

Capacity:  The first source of mortgage repayment in an apartment loan is the Net Operating Income (NOI). Earlier we saw that a bank will almost never make a portfolio loan at 100% of value because it’s too risky. Similarly, the bank won’t make a loan that requires every cent of the NOI to cover monthly principal and interest payments: it’s too risky. A common Debt Coverage Ratio (DCR) is 1.20, meaning that the maximum monthly payment permitted under the mortgage cannot exceed 83% of the monthly NOI (NOI divided by DCR).  Other common DCR’s range from 1.10 to 1.50, depending on the details of the loan.

DCR’s are computed as follows:

  • Step 1:  Determine annual NOI and divide by 12. That’s your monthly NOI. ($120,000      divided by 12 = $10,000 monthly)
  • Step 2: Divide monthly NOI by the necessary DCR.      The resulting number is the maximum monthly principal and interest payment      the lender will permit. For example, $10,000 monthly NOI divided by 1.20      equals a maximum payment of $8,333.

Obviously, the amount of the loan is affected by market interest rates. A payment of $6,400 will service a loan of $1,341,000 at 4% interest (all numbers rounded). If interest rates went up, at 5% the same payment only will service $1,192,000. At 6% the maximum loan would be $1,067,000. The difference between $1,341,000 and $1,067,000 is 20%.

Like most things that are usually purchased with money that has to be paid back, the apartment market is uber-sensitive to available financing. The greater the loan the building will support, the higher the purchase price. As soon as interest rates go up the maximum loan the building will support will be less, and the value will drop. Banks know this and protect themselves through adjustments in LTV and DCR requirements, so understand that all the figures we’re using in this column are illustrative only.

If you were a lender and believed interest rates were going to go down, would you seek a competitive advantage and possibly take a chance on raising LTVs to 80%? Why not? As rates go down the building’s value would go up and we would quickly be back in the 70 – 75% range. The banker gets a nice bonus.

You still have your banker’s hat on, and you still believe rates will decline. You’re seeking a competitive advantage and the end of year bonus that comes with it. Could you adjust your DCR hurdle to, say, 1.10, at least for adjustable rate loans? You’ll pick up a lot of the business other banks are still turning down and, as rates drop the DCR on the mortgage you signed off on automatically goes up. Your bonus is based partially on how many loans you originate. Can’t you just see that bonus getting bigger and bigger?

Ok, so a declining interest rate environment means apartment values go up because the price of money is going down and the same payment will service a bigger loan.

But we’re not in Kansas anymore. We’re beginning to witness an increasing rate environment. Reuters reported recently that 5, 7, and 10 year yields are the highest in almost two years and that “Strategists see Fed tapering as likely in September [2013]”.

In this new environment of rates up / values down one would expect lenders to lower their LTV ratios and require more of a down payment for purchases. The DCR is also at risk, and it’s reasonable that lenders would require more of a cushion and adjust DCR higher. At 1.25 DCR our hypothetical loan payment of $6,400 would service $1,341,000 at 4% interest, but only $1,067,000 at 6% interest. If you were a lender, wouldn’t you reduce your risk, when interest rates are going up, by raising your DCR? Remember, things have changed and your bonus is now riding on how few losses your loans accrue.

So in an increasing rate environment apartment values go down because the rent on borrowed money is going up.

With this background we can begin to look at what happened the last time we were in this point of the interest rate cycle. It’s reasonable to speculate that we’ll see the same things this time around. Sellers will continue to be emotionally locked into the prices that were reached during the peak of the market; buyers will not be able to perform due to higher interest rates, lower LTV’s, and higher DCR’s. The way across this chasm is, traditionally, seller carried financing.

Seller Financing  

Sometimes seller financing works. A careful attorney can draft a agreement that protects the seller in some ways (alienation clause, etc.) and, if the down payment and other buyer qualifications are at least comparable to what the banks demand it may all turn out well in the end. But oftentimes this doesn’t happen.

Hypothetical example: Assume the seller has no other significant assets except her apartment building. She wants to sell her units and retire. If she insists on bank financing she may well walk away with $1,000,000 cash which she could invest at the present dividend yield of the S&P 500, currently 1.9%. That would give her an income of $19,000 a year ($1,583 / monthly). That’s no good: who can retire on sixteen hundred dollars a month?

If, however, she carries back the mortgage herself at, say, 6% per year interest only, she would receive $5,000 monthly. That’s a huge difference.  It’s the difference between living in modest comfort or suffering in penury.  Unsurprisingly, she chooses modest comfort.

That means that she is motivated to accept a minimal down payment, but there are consequences to that. The smaller the down payment the more interest she’ll receive each month, and that’s a good thing. But it also means that the buyer has little skin in the game and may well become less and less invested in the project. Conceivably, he could cease monthly payments, delaying foreclosure for a year or more, first through false promises to pay then through court actions and title changes, all the while retaining the rents so he can, at a minimum, recover all or most of his (very low) down payment. In an “owner-carry” situation, the borrower controls events.

Having no other significant assets, and having placed her in a position where her monthly checks are cut off, the buyer may seek to re-negotiate. It’s a two step program.

  •  Step 1: “You know that $1,000,000 note you’re carrying? The note that I’m not paying? If you play along with what I tell the bank, I’ll refinance and pay you $250,000. Yeah, I know it was for  $1,000,000 but it’s not worth that anymore because I’m not making the payments. So I can only offer you $250,000.”
  • Step 2: “You know that $250,000 I promised? Will you carry the note?”

Takeaway: Don’t sell if you can avoid it. If you do sell, don’t carry paper.

Disclaimer:  I am neither an attorney nor an accountant. This article may sound like good advice, but it probably isn’t. Don’t rely on it.

Klarise Yahya is a Commercial Mortgage Broker. If you are thinking of refinancing or purchasing five units or more, Klarise Yahya can probably help. Find out how much you can borrow. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email [email protected]

If you’ve missed some of the prior articles, basic “beginner” guidelines on successful investing are in my book “Stairway to Wealth” available at

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